Bank Municipal Bond Holdings and Mortgage Lending Standards

Abstract

We show in this paper that tax exemptions on income from municipal bonds distort bank mortgage lending standards. Banks in states with a larger tax exemption hold more municipal bonds on their balance sheets. These holdings expose banks to local risks, in particular to real estate risk as municipal bonds are financed to a large extent via property tax revenues with a large elasticity with respect to house prices. We show that banks with a higher share of municipal bonds on their balance sheets divert their mortgage originations out of their home states by relaxing their mortgage lending standards. We provide evidence that this geographical diversification is costly in that banks originate mortgages with lower FICO scores, and higher loan-to-value ratios and interest rates away from their home states. We use the exogenous shift in municipal bond prices, driven by the 2010 rating recalibration by Moody's, to establish the causal relationship between municipal bond holdings and mortgage lending standards.

Keywords: Municipal bonds, Mortgage originations, Lending standards, Geographical diversification

JEL Classification: G21, G28, G51, H23, H71, H72, H73, H74